NEWS / Foreign Exchange

The Spreading Contagion

The credit crisis is continuing to spread while the housing situation looks more and more like a bottomless pit. At the same time evidence keeps accumulating that shows the malaise spreading to the rest of the economy.

This week Merrill Lynch wrote off $8.2 billion in assets and the word on the Street is that there is more to come. Just a few weeks ago Merrill estimated the write-down at $5 billion. The firm says that the new number is not the result of any newly-found bad assets, but a judgment call on what discount to take from the original valuations. The huge disparity therefore either indicates the wide degree of latitude various financial institutions have in determining the amount of write-downs to take or, on the other hand, indicates a deterioration of perceived value over the last few weeks. Either way, it makes us wonder how many more write-downs are in store for companies that have already taken one write-down and how many other institutions have yet to take their first one.

At the same time it is still unclear whether the Treasury-sponsored SIV rescue plan will do any good and whether it will it even be implemented. On the surface it looks like a temporary holding action aimed at keeping the assets off the books and preventing a showing of their real values. Already a number of prominent voices such as Buffet and Greenspan have expressed their doubts. Since the plan was announced it has become even more apparent that the SIVs are a global problem. Tango Finance, one of the world??™s largest SUVs, is selling assets. The firm had assets of $14 billion in July. Chyne Finance with assets of $6.6 billion said it may have trouble paying its debts. Rhinebridge ($2.2 billion), run by IKB Deutsche, may also not be able to pay all of its debts.

Meanwhile the continually worsening housing situation threatens to bring about even more credit problems and a hard landing for the economy. September existing home sales were down 8% for the month and 19% year-to-year with inventories soaring to a 10.5 months supply. Unlike new homes, you can??™t alleviate the supply situation by halting new building??”these houses are already here. With mortgage quality continuing to deteriorate and foreclosures likely to rise, a significant increase of additional houses on the market is virtually a sure thing. New home sales were up 4.8% in September, but only with the help of a sharp downward revision of August sales. Furthermore, according to NAHB chief economist David Seiders the report indicating a 38% increase in sales in the West was highly questionable. The new housing sales numbers also do not include cancellations, which ranged from 27% to 68% among seven leading home builders.

In addition the evidence that the economy is softening outside the housing sector is quite clear. September chain store sales were down 1.5% and are down over 2% since late July. A number of leading retailers have reduced their expectations including Target, Talbots and Coach. UPS reduced their estimates on the expectation of slower retail sales, and they are in a position to know. September industrial production was up only 0.1% following a flat reading in August. Over the last four months payroll employment has increased by an average of 90,000 compared to 143,000 in the prior four months. In the last two weeks initial unemployment claims has jumped to near the top the range that has been in force since mid-2006. The semiconductor manufacturers??™ book-to-bill ratio is at 81, a two-year low while September orders were down 10.6%. Caterpillar surprisingly lowered its forecast, blaming widespread economic weakness. The outlook for capital expenditures is also not encouraging. New orders for durable goods ex-defense and transportation is down 5% from a year earlier while the NABE survey of business confidence is falling sharply. In addition Ward??™s is reporting a sharp decline in median and heavy-duty truck sales.

Those looking for strength from abroad may also be disappointed. The German government recently cut its 2008 economic forecast, blaming a strong Euro, high oil prices and credit market turmoil. The Eurozone PMI is down sharply. The housing boom in Europe has also been cooling off significantly. Japan??™s economy continues to be sluggish. Together, the U.S., the EU and Japan account for about 70% of world GDP. The other 30% have relatively low domestic consumer spending as a percent of GDP, and are heavily dependent on exports to the other 70%. In our view the global economy is far from immune to a hard landing in the U.S.

The stock market, despite its recent gyrations, has remained at an elevated level based on the widespread belief in a soft landing, continued ease by the Fed and strong global growth. In our view that belief will become as discredited as the belief that the end of the dot-com boom and the housing boom would be contained, that derivative instruments eliminated risk and that subprime loans were safe. The current market discounts nothing ahead of time and does not connect the dots. Instead it reacts to the news each day almost as if the prior day did not exist. In our view the news on the economy will get worse and the market will then react strongly on the downside.